GŁnter Reiner
 
 
The Legal Nature of Financial Derivatives

("Derivative Finanzinstrumente im Recht")



Abstract


  In his post-doctural thesis Professor Reiner develops the so called Failure-of-Consideration Approach (“Zweckverfehlungsansatz”, “causa-Ansatz”) which explains the existing of unenforceable risk contracts (wager, gambling contracts) on the one hand and enforceable risk contracts (for instance insurance contracts, most of futures, forwards, options and swaps) on the other hand. His approach describes the unenforceable nature of gambling contracts as a consequence of a failure of consideration.

A bilaterally binding contract is or at least should be unenforceable for a lack of consideration, whenever it is sure already at the moment of its conclusion that one of the parties will fail to achieve the purpose of its obligation towards the other party. That is the situation of a wager or gambling contract: One of the parties will necessarily be frustrated in the end.

In contrast to wager or gambling contracts, the situation of risk contracts like insurance contracts is quite different, which is why those contracts are enforceable. The insured party will achieve its object – getting security - for sure, regardless whether the insured risk will realize or not and she will not be frustrated if the insured risk does not occur. Therefore, from an ex-ante point of view, it is possible that both parties (including the insurer) derive a benefit from the contract. For the same reason a financial derivative contract should be legally binding, if and only if the parties can close their risk position with an offsetting (hedging) transaction at any time of the contract period (derivatives in the proper sense of the term). In that case, the contingent obligations of the contract are continuously valuable (and duplicatable) at market during the whole contract period. That is why such a derivative contract is a real exchange contract with a significant consideration just like an insurance contract and unlike a wager or gaming contract subject to the gaming exception. To meet the prerequisite of being hegdeable there must be either a liquid market for the derivative’s underlying or, at least, for the derivative contract itself.

In addition, the fact that the contingent obligations of derivatives (in the proper sense of the term) have a  determinable value in itself at any time during their term implies some other legal consequences, especially regarding accounting and insolvency law.

There are good reasons to consider that, in the case of insolvency proceedings, ongoing derivative contracts are not ordinary executory (non-performed) contracts which entitle the insolvency administrator to opt between closing out or fulfilment of ongoing contracts (i.e. the receiver's right to request or reject performance). As the risk position of ongoing derivatives (in the above sense) can be hedged or replaced (dublicated) by alternative investments of both parties with a third person at any time, there is no real need for the continuation option. On the contrary, with regard to general principles of contract law it would be more coherent to consider an ongoing derivative as closed out ipso iure at the moment of the institution of the insolvency proceedings and to settle the derivative on the basis of its current market value. From this perspective, “Close-out Netting” and “Single Agreement” provisions in master agreements for financial derivatives (such as sections 2 and 6 of the 2002 ISDA Master Agreement) can conflict neither with the insolvency administrator’s right to repudiate or fulfil nor with the general restrictions on insolvency set-off. Thus, special netting legislation, entering into force in more and more countries (https://www.isda.org/2018/06/12/status-of-netting-legislation/) in order to promote legal security, is fundamentally (but not always in the detail) compatible with the basic principles of contract and insolvency law.

The above statements about the gambling exception and the insolvency law only apply to the extent that the premise is fulfilled, i.e. that derivatives in the proper sense are involved: instruments that can be hedged at any time or, in other words, instruments that have a determinable value throughout their entire term. Such a value may be empirically ascertainable (market value) if a liquid secondary market exists for the instrument. However, it is also sufficient if the value can be calculated theoretically with corresponding recognised mathematical models on the basis of the no-arbitrage principle ("fair value"). The theoretical calculability places certain demands on the underlying instrument. If the underlying is too special or unique, as is the case with certain exotic derivatives, a serious valuation may only be possible in terms of a minimum price or may no longer be possible at all. These circumstances should be taken into account when granting legal privileges to derivatives under gaming and insolvency law.


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